The Role of Accounting in Business

Introduction

A New Form of GPS: The Gregarious People Seeker

Things are moving so fast we really don't know what's going to happen.

 - Naveen Selvadurai, cofounder of Foursquare

Let's say that you're doing your economics homework, trying to calculate the effect of the recession on room rates in Fort Lauderdale. For some reason, you get a sinking feeling that your friends are out somewhere having fun without you. What's a quick way to find out where they are and what they're up to? If you're signed up, you can "check in" with the Foursquare app on your smartphone, tablet PC, or whatever device you use to connect to a wireless network. Foursquare is a mobile social network, and in addition to the handy "friend finder" feature, you can use it to find new and interesting places around your neighborhood to do whatever you and your friends like to do. It even rewards you for doing business with sponsor companies, such as local restaurants.

Foursquare, which has been getting a lot of buzz lately, was started in 2009 by two young entrepreneurs, Dennis Crowley and Naveen Selvadurai. It's already attracted more than a million users, and Crowley and Selvadurai are understandably enthusiastic about their prospects. Not everybody, however, is as optimistic as they are. Right now, Foursquare is bringing in money and growing, but let's face facts - it's a start-up and it's barely two years old. Among the experts who pay attention to the business of software apps, Foursquare has both optimists and skeptics, and, as usual, there a lot of people who think that Crowley and Selvadurai should take the money and run - that is, sell out to a larger company and move on.

Clearly, Crowley and Selvadurai have some questions to answer and - at some point, if not necessarily right now - decisions to make. This is where they'll have to rely on an accountant, because they'll need somebody with a knowledge of accounting to help them ask and answer the right questions and formulate and make the right decisions: How much revenue are we bringing in? Can we increase it? What are our expenses? Will they continue to get higher or can we cut them? How much money are we actually making? Are we operating at a profit or a loss? How much do we have invested in the company? How much debt do we have? Can we pay our bills on time? If we need more money, where can we get it? How much cash do we have on hand? How much cash comes in each month and how much goes out? How long will it last? How much is our business really worth? If we decide to sell it, how much should we ask for it? Is it a good idea to put more of our own money into the venture? What are the odds that Foursquare will succeed?

In this chapter, we'll learn how to gather, summarize, and interpret accounting information and how to use it in making business decisions like the ones facing Crowley and Selvadurai.

 This text was adapted by Saylor Academy under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 License without attribution as requested by the work's original creator or licensor.

The Role of Accounting

Learning Objectives

1. Define accounting and explain the differences between managerial accounting and financial accounting.
2. Identify some of the users of accounting information and explain how they use it.

Accounting is often called "the language of business". Why? Because it communicates so much of the information that owners, managers, and investors need to evaluate a company's financial performance. These people are all stakeholders in the business - they're interested in its activities because they're affected by them. In fact, the purpose of accounting is to help stakeholders make better business decisions by providing them with financial information. Obviously, you wouldn't try to run an organization or make investment decisions without accurate and timely financial information, and it's the accountant who prepares this information. More importantly, accountants make sure that stakeholders understand the meaning of financial information, and they work with both individuals and organizations to help them use financial information to deal with business problems. Actually, collecting all the numbers is the easy part - today, all you have to do is start up your accounting software. The hard part is analyzing, interpreting, and communicating the information. Of course, you also have to present everything clearly while effectively interacting with people from every business discipline. In any case, we're now ready to define accounting as the process of measuring and summarizing business activities, interpreting financial information, and communicating the results to management and other decision makers.

Fields of Accounting

Accountants typically work in one of two major fields. Management accountants provide information and analysis to decision makers inside the organization in order to help them run it. Financial accountants furnish information to individuals and groups both inside and outside the organization in order to help them assess its financial performance.

In other words, management accounting helps you keep your business running while financial accounting tells you how well you're running it.

Management Accounting

Management accounting plays a key role in helping managers carry out their responsibilities. Because the information that it provides is intended for use by people who perform a wide variety of jobs, the format for reporting information is flexible. Reports are tailored to the needs of individual managers, and the purpose of such reports is to supply relevant, accurate, timely information in a format that will aid managers in making decisions. In preparing, analyzing, and communicating such information, accountants work with individuals from all the functional areas of the organization - human resources, operations, marketing, and finance.

Financial Accounting

Financial accounting is responsible for preparing the organization's financial statements - including the income statement, the statement of owner's equity, the balance sheet, and the statement of cash flows - that summarize a company's past performance and evaluate its current financial condition. In preparing financial statements, financial accountants adhere to a uniform set of rules called generally accepted accounting principles (GAAP) - the basic principles for financial reporting issued by an independent agency called the Financial Accounting Standards Board (FASB). Users want to be sure that financial statements have been prepared according to GAAP because they want to be sure that the information reported in them is accurate. They also know that they can compare the statements issued by one company to those of another company in the same industry.

While companies headquartered in the United States follow U.S.-based GAAP, many companies located outside the United States follow a different set of accounting principles called International Financial Reporting Standards (IFRS). These multinational standards, which are issued by the International Accounting Standards Board (IASB), differ from U.S. GAAP in a number of important ways. IFRS, for example, is a little stricter about the ways you can calculate the costs of inventory, but we're not going to dwell unnecessarily on such fine distinctions. Bear in mind, however, that, according to most experts, a single set of worldwide standards will eventually emerge to govern the accounting practices of both U.S. and non-U.S. companies.

Who Uses Financial Accounting Information?

The users of managerial accounting information are pretty easy to identify - basically, they're a firm's managers. We need to look a little more closely, however, at the users of financial accounting information, and we also need to know a little more about what they do with the information that accountants provide them.

Owners and Managers

In summarizing the outcomes of a company's financial activities over a specified period of time, financial statements are, in effect, report cards for owners and managers. They show, for example, whether the company did or didn't make a profit and furnish other information about the firm's financial condition. They also provide information that managers and owners can use in order to take corrective action.

Investors and Creditors

If you loaned money to a friend to start a business, wouldn't you want to know how the business was doing? Investors and creditors furnish the money that a company needs to operate, and not surprisingly, they feel the same way. Because they know that it's impossible to make smart investment and loan decisions without accurate reports on an organization's financial health, they study financial statements to assess a company's performance and to make decisions about continued investment.

According to the world's most successful investor (and third-richest individual), Warren Buffett, the best way to prepare yourself to be an investor is to learn all the accounting you can. Buffett, chairman and CEO of Berkshire Hathaway, a company that invests in other companies, turned an original investment of $10,000 into a net worth of $35 billion in four decades, and he did it, in large part, by paying close attention to financial accounting reports.

Figure 12.2 Warren Buffet

Government Agencies

Businesses are required to furnish financial information to a number of government agencies. Publicly owned companies, for example - the ones whose shares are traded on a stock exchange - must provide annual financial reports to the Securities and Exchange Commission (SEC), a federal agency that regulates stock trades. Companies must also provide financial information to local, state, and federal taxing agencies, including the Internal Revenue Service.

Other Users

A number of other external users have an interest in a company's financial statements. Suppliers, for example, need to know if the company to which they sell their goods is having trouble paying its bills or may even be at risk of going under. Employees and labor unions are interested because salaries and other forms of compensation are dependent on an employer's performance.

Figure 12.3 "Management and Financial Accounting" summarizes the main differences between the users of management and financial accounting and the types of information issued by accountants in the two areas. In the rest of this chapter, we'll learn how to prepare a set of financial statements and how to interpret them. We'll also discuss issues of ethics in the accounting communities and career opportunities in the accounting profession.

Figure 12.3 Management and Financial Accounting

Key Takeaways

• Accounting is a system for measuring and summarizing business activities, interpreting financial information, and communicating the results to management and other stakeholders to help them make better business decisions.
  
  
• Accounting can be divided into two major fields:
  • Management accounting provides information and analysis to decision makers inside the organization (such as owners and managers) to help them operate the business.
  • Financial accounting provides information not only to internal managers, but also to people outside the organization (such as investors, creditors, government agencies, suppliers, employees, and labor unions) to assist them in assessing a firm's financial performance.
    
    
• U.S. and non-U.S. companies follow different sets of standards in preparing financial accounting reports:
  • U.S. companies adhere to a uniform set of rules called generally accepted accounting principles (GAAP), which are issued by an independent agency called the Financial Accounting Standards Board (FASB).
  • Many companies outside the United States follow a set of accounting principles called International Financial Reporting Standards (IFRS), which are issued by the International Accounting Standards Board (IASB).
• Experts expect that a single set of worldwide accounting standards will eventually emerge and be followed by both U.S. and non-U.S. companies.

Exercise

1. Who uses accounting information? What do they use it for, and why do they find it helpful? What problems would arise if they weren't provided with accounting information?